Why Real Estate is Not a Short Term Inflation Hedge, and What To Do About It If You Own Real Estate.

Brenden Millstein
June 7, 2022
5 min read
https://www.carbonlighthouse.com/why-real-estate-is-not-a-short-term-inflation-hedge-and-what-to-do-about-it-if-you-own-real-estate

In this article we’ll cover why building valuations are going down as interest rates rise, despite the commonly held belief that owning real estate is an inflation hedge, and what to do about it if you own real estate.

Interest rates are going up. So that means stock valuations are going down. Right? Yes. But why? Here’s how in three bullets:

  1. When the Fed increases interest rates, the return investors can get on bonds increases. (How the Fed raises interest rates? Great article here.) Bonds pay interest, so bonds provide higher returns when interest rates go up. 
  2. Bonds are lower risk than stocks. In the case of Treasury bonds, the risk of default is equal to the risk of the federal government of the United States of America defaulting on its loans. This was once considered zero, and is still considered near zero. Because bonds are lower risk than stocks, but the rate of return has just gone up thanks to increased interest rates, capital flocks to bonds. 
  3. Market forces set stock prices (and bond prices to a large degree). As capital flocks to bonds, less capital is available to purchase stocks. Some investors may even sell stocks and use the proceeds to buy bonds. Supply and demand kick in: more stocks are available, and less money is trying to buy them, so prices fall. 

Real estate is often considered an asset class that is an “inflation hedge”, a place to park money that will provide a relatively stable return regardless of interest rates and inflation. But real estate valuations -- the value of a building -- are also coming down. What’s going on? 

There’s a difference between a long-term inflation hedge, and the short term. Long-term, real estate remains a solid asset class to invest in when it comes to inflation. In the short term, there’s a crunch. Specifically, short-term commercial real estate has relatively fixed income streams -- multi-year rental agreements -- but variable costs, specifically debt. Some mortgages are floating rate, e.g. LIBOR + 2%. This means as interest rates go up mortgage costs go up. But income is fixed, so returns go down. 

Even for mortgages which are fixed rate, mortgage terms are often relatively short in commercial real estate compared to the hold period, for example, a 5yr mortgage term compared to a planned 10yr hold period. Refinancing, getting a new mortgage to payout the expiring mortgage, is a frequent event. As interest rates go up, refinancing rates go up. If the cash streams aren’t there to support it, the landlord may be forced to sell, increasing supply of building stock without increasing demand and driving prices down. If the landlord can refinance, returns are lower, which also drives prices down.

Thus while real estate may be a good asset class to invest in to lower long-term inflation risk, in the short term, real estate prices go down just like stock prices when interest rates go up. 

Great, what do we do about it? There are two levers to increasing building valuations, though simple does not mean easy:

  1. Get cheaper debt
  2. Get more rent

Cheaper debt is off the table right now. So the focus is on rent. But how? The office market isn’t exactly roaring back, and multi-family, industrial, and medical office assets are already relatively well-leased. The answer is “ancillary income”, or lesser known rents like cell-antenna roof leases, billboard leases, and renting access to your mechanical rooms and roof.

We can rent access to back-of-house spaces? That’s exactly what Carbon Lighthouse’s SMARTincome product does: Carbon Lighthouse installs sensors in the mechanical spaces and roof, and then pays market rate rent (or higher) for access to the space so we can access the data coming off of those sensors. For a medium-sized portfolio, the rent we pay typically increases the value by $30M - $50M.

If you’re interested in getting market rate rent for previously un-leasable space across your portfolio, get in touch with our sales team here.

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Brenden Millstein
June 7, 2022
5 min read
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